Santa Claus (rally) is coming to town!
It’s that time of the year again! Christmas is coming and everyone is getting into the festive mood.
And while many of us are looking forward to see what presents Santa Claus has in his bag for us – assuming we have been good boys and girls – there is actually another year-end phenomenon that the traders among us are keeping an eye out for.
We are of course referring to the Santa Claus Rally.
What is the Santa Claus Rally?
The Santa Claus Rally (also sometimes known as the December Effect) refers to the substantial rise in stock prices usually observed during the week between Christmas and New Year’s Day.
Many theories have been put forth to try to explain the reason for this seemingly annual occurrence.
Some of these theories come across as a bit quizzical or trivial, such as people investing simply because they are in a happier mood or conversely, that the market pessimists have taken a break for the holidays.
On the other hand, some other theories do seem more practical and logical, such as people investing because they have spare cash/capital from their year-end bonuses or are closing out trades due to tax and accounting considerations.
What triggers the Santa Claus Rally?
Putting aside the more unlikely causes behind the Santa Claus Rally, here are some of the more possible practical explanations.
Companies typically have 31st December as their end-of-period reporting date. Investment managers will try locking in their tax reductions before that time by participating in what is called ‘tax-loss selling’.
In a nutshell, this involves selling some of the stocks within their investment portfolio that have an unrealised paper loss in order to offset against capital gains from their other assets/stocks.
However, selling these stocks might end disrupting their portfolio allocation and thus in order to try and re-balance the portfolio allocation, the investment managers will look to purchase similar stocks that provide the same exposure or diversification as the previous stocks that were sold off, causing demand for these other stocks to increase along with their share prices.
Interestingly, it is then likely that those same stocks that were previously sold by the investment manager might now seem like a good bargain for other buyers who would be tempted to pick up those stocks in turn.
Spare capital or cash
People are more likely to invest when they have spare cash/capital at their disposal and this could be made possible when they receive their year-end bonuses. As such, with an added influx of people buying more stocks during this festive season, it would typically cause the prices of stocks to increase.
Anticipation of the January Effect
Some investors buy stocks in December in order to reap a profit when the January Effect comes along. The January effect is a similar seasonal increase in stock prices, much like the Santa Claus Rally itself, except that it happens during the following month of January.
Ironically, a major cause of it is related to the events that occurred back in December.
For example, a lot of the investors who sold certain stocks in December for tax purposes will be buying back those same stocks and putting them back in their portfolio.
As for people who invest more when they have additional cash in hand, there’s a large group of them who only receive their year-end bonuses in January and therefore holds off buying the stocks till then. As such, all these reasons result in an overall rise in share prices.
Will there be a Santa Claus Rally in 2016?
Taking into account the topics we have specified above, and assuming that other factors are constant, how is the macroeconomic environment shaping up for this 2016 year-end?
For one thing, if you are active in the US markets, the market there has been on a strong rally lately on the back of Trump’s upcoming presidency.
The ‘Trump Effect’ has spurred the stock market with many investors betting that Trump will fulfil his pledge and cut corporate taxes and regulations, which would translate to higher profits.
Added to this are strong recent economic indicators for the US such as GDP growth and employment numbers. The fast-recovering economy further heightens optimism amongst businesses and consumers, which brings about increased spending and further reinforces the economic recovery.
Ironically, a strong economy might lead to the Federal Reserve Open Market Committee (FOMC) implementing further rate hikes, which might then be a growth dampener.
This is because domestically, this means borrowing costs are higher and thus spending might be curbed. Also, US exports will cost more since the US Dollar would have strengthened compared to other currencies due to the rate hike.
As for markets outside of the US, especially the emerging markets, a Fed rate increase might actually result in a positive outcome in the form of a relief rally.
This is because, once and for all, it puts to bed worries that investors have been harbouring about capital flight since early this year.
A Fed action of this nature could send out a clear signal that no further hikes will take place for the next three to six months and thus, this would enable investors to realign their investment holdings with the revised interest levels and reassess their portfolio strategy going into 2017.
You better watch out, I’m telling you why
Having said all this, nothing is ever guaranteed and the Santa Claus Rally is not always predictable. As such, investors should remain extremely wary and not take anything for granted when it comes to market seasonal patterns.
As tempting as it might be to take a shortcut in doing the required homework and pinning your hopes purely on what appears to be a repeating annual occurrence, investors should instead still adhere to making sound investment decisions based on fundamentals and plenty of research.
This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of ZUU.